Asset Pricing Implications of a New Keynesian Model

Abstract

We investigate the behavior of asset prices in a typical New Keynesian macro model. Using a second-order approximation, we examine bond and equity returns, the equity risk premium, and the behavior of the real and nominal term structure. As documented in the literature, our results suggest that introducing real rigidities to the model increases risk premia. Nevertheless we that find that, in a world dominated by productivity shocks, increasing nominal rigidities reduces risk premia. Such rigidities only enhance risk premia when economic dynamics are mainly driven by monetary policy shocks. The results imply that, unlike in endowment frameworks, matching asset pricing facts in macro models will require attention to the composition of shocks, not just the specification of investor preferences.

Risk Premiums, Nominal Rigidities and Limited Asset Market Participation

“…where for any generic variable h, ∆h t = h t − h t−1 . De Paoli et al (2010) show that the real rate can be expressed as:…”

“…We assume that the nominal wage adjustment cost is intangible. In section 2.6 we make the same assumption for the price adjustment cost, following DePaoli et al (2010). In a separate exercise, we solved the model with tangible nominal adjustment costs and found that our results are unaffected.…”

“…For instance, contrary toUhlig (2007), we have monopolistic competition in both labor and goods markets and our productivity process is different from his. However, even in our version of the Uhlig model it is possible to obtain high risk premia, which suggests that we capture the essential features of it 13. In particular, we set Ω = e 1−µ w µ 1−µ14 We are forced to impose flexible prices here because with sticky prices and LAMP the model is indeterminate.…”

Monetary and Fiscal Policy in Times of Crisis: A New Keynesian Perspective in Continuous Time

“…Instead, we extend the NK framework of Paoli et al . () by defining different term structures and rigidities and moving the analysis to an open‐economy setting. In the absence of frictions, the model exhibits the well‐known equity and term premia puzzle.…”

“…() and Paoli et al . () and model the term structure recursively. The one‐period nominal bonds deriving the standard relationship are given by where is a shock to a one‐period nominal bond and λ t is the Lagrangian from the household's FOCs.…”